When Private Equity Firms Give Retirees the Short End

That question is crucial for any investor. But it poses a special challenge for retired firefighters, police officers, teachers and other employees who may not know that their retirement money is being held in private equity funds.

These are opaque and costly investment vehicles that borrow money to buy companies and sell them, ideally, for a profit. The secrecy under which this $3.5 trillion industry operates has essentially required millions of people whose pensions are invested in these funds to simply trust that they are being treated fairly.

Yet the funds impose fees under terms that create conflicts of interest between investors and general partners who run private equity firms. A little-known practice involves discounts that the firms obtain from lawyers and auditors but do not always share fully with investors. A dive into regulatory filings over the last month revealed that 12 private equity firms said they had actual conflicts of interest in connection with such discounts, while 29 more described potential conflicts. Altogether, the 41 firms oversee almost $600 billion in client assets, documents show.

The disclosures appear in documents the firms filed with the Securities and Exchange Commission as registered investment advisers. For example, Carlyle Investment Management, the $113 billion firm led by David M. Rubenstein, states that in certain circumstances, lawyers, auditors and other vendors charge Carlyle rates that are better than those charged to its investors. As a result, Carlyle receives “more favorable rates or arrangements than those payable by advisory clients or such portfolio companies,” the filing said.

Carlyle declined to comment.

The implications of such arrangements seem troubling: Wealthy private equity funds receive discounts on legal, accounting and other outside work while pension fund investors, like retired bus drivers, librarians and teachers, pay full freight or, in some cases, a premium.

These discounts — and the potential and actual conflicts associated with them — have drawn scrutiny from the S.E.C. The Blackstone Group, the private equity giant run by Stephen A. Schwarzman, said in a filing last month that the S.E.C. was looking at the firm’s practices “relating to the application of disparate vendor discounts to Blackstone and to our funds.”

Although Blackstone said it had changed these practices in 2011, documents it filed in March as a registered investment adviser note that its funds or portfolio companies — both primarily owned by investors — may still pay more in service fees than Blackstone itself.

“Advisers and service providers, or their affiliates, often charge different rates or have different arrangements for specific types of services,” the filing states. “Therefore, based on the types of services used by the funds and portfolio companies as compared to Blackstone and its affiliates and the terms of such services, BMP L.L.C. or its affiliates may benefit to a greater degree from such vendor arrangements than the funds or such portfolio companies.”

A Blackstone spokesman declined to comment further on the filing.

The S.E.C. declined to comment about the private equity firms’ fee practices. But in a speech last month, Marc Wyatt, acting director of the S.E.C.’s office of compliance inspections and examinations, told a private equity industry group, “We can expect additional enforcement recommendations involving undisclosed and misallocated fees and expenses as well as conflicts of interest.”

Private equity firms oversee the assets of endowments, wealthy individuals and pension funds — which indirectly expose huge numbers of unsophisticated people to them. The firms typically charge the investors 1.5 to 2 percent of assets annually, as well as 20 percent of any gains their portfolio companies generate. The firms usually require that the investments remain in the funds for at least five years.

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Stephen A. Schwarzman, chief of the Blackstone Group. The private equity firm has disclosed in public filings that it has been getting discounts that investors in their funds may not be receiving.CreditTodd Heisler/The New York Times

Returns from private equity funds, once strong investment alternatives, have on average trailed those of the broad stock indexes over the last five years.

As returns diminished, investors focused on the sizable private equity fees. In addition to hefty management fees, they include charges for services like advice on mergers and acquisitions for companies in fund portfolios. Many investors have demanded that the firms reimburse them for a portion of such charges.

Regulators have identified certain fees as problematic. One example is the so-called monitoring fee, which investors pay to private equity firms, ostensibly for overseeing portfolio companies in the funds.

Often, though, the firms charged investors for the monitoring of companies no longer in fund portfolios. After the S.E.C. highlighted this practice last year, some firms, like Blackstone, stopped doing it.

According to Preqin, a data research firm, public pension funds’ investments in private equity totaled $321 billion in 2015, up from $248 billion in 2011. Some big pensions are throttling back, though. On Monday, the $300 billion California Public Employees’ Retirement System announced that it was reducing its private equity managers to 30, from 98, in a move to pare portfolio costs.

Calpers’s decision follows a series of disclosures that have emerged since the Dodd-Frank law in 2010 required private equity firms with more than $150 million in assets under management to register as investment advisers and make public filings about their operations.

In these filings, private equity firms delineate possible or realized conflicts posed by variations in service fees charged by outside law firms and others.

Consider a filing by Apollo Global Management, the private equity behemoth overseen by Leon Black. It states that Apollo and its funds receive discounts on plain vanilla legal work such as employment contracts and regulatory filings. Apollo and its investors also receive discounts, its filings show, on charges known as broken-deal fees, which arise when a proposed acquisition or sale of a portfolio company is not completed.

No discounts are given on investment transactions, including those charged to investor-owned funds managed by Apollo, however. In fact, Apollo says that for these transactions, outside service providers often receive a premium beyond the level of customary rates.

“Legal services rendered for investment transactions,” the filing states, “are typically charged to the Apollo Private Equity Managers, their affiliates and clients on a ‘full freight’ basis or at a premium.” Because investment transactions typically occur in investor-owned funds, they end up paying the bulk of the premium prices.

Apollo’s spokesman, Charles V. Zehren, said in a statement: “Apollo has long been a leader in implementing best practices relating to fee arrangements with service providers. The fee and discount structures that we have negotiated for Apollo are made available to our fund clients and to all portfolio companies that wish to participate.”

But J. J. Jelincic, a member of the Calpers board, has criticized the Apollo arrangement: Making investors pay higher prices, he says, allows the firm to reduce its own costs.

“It puts the lie to the fact that we are partners with the private equity firms,” Mr. Jelincic said. “We are simply a source of income to the general partners; we are not partners.”

Private equity investors have not typically been informed of the vendor discount arrangements or of the total amount of money involved. Several members of Calpers’s board and staff learned of the Apollo practice only recently, Mr. Jelincic said. They received a presentation about it from Michael Flaherman, a former chairman of the investment committee of the Calpers board who is conducting research into private equity as a fellow at the Edmond J. Safra Center for Ethics at Harvard University.

Mr. Flaherman declined to comment on the discussions.

Joe DeAnda, a Calpers spokesman, said in a statement: “Calpers has long been a leader in advocating for fee economies and transparency, including in private equity. We have been actively engaging with some of our private equity partners to help improve the disclosure and data available, and have been closely monitoring the regulatory announcements and attention around this subject.”

First Reserve Management, a $17 billion private equity firm with offices in Houston, London and Greenwich, Conn., is another whose filings indicate that outside vendors provide it with discounts that may benefit the firm more than its investors.

A First Reserve document states that “advisers and service providers, or their affiliates, may charge different rates or have different arrangements for services provided to First Reserve and its affiliates as compared to services provided to the First Reserve Funds and their portfolio companies.” That could hurt investors.

The document says it could result “in more favorable rates or arrangements than those payable by the First Reserve Funds or such portfolio companies.”

First Reserve did not respond to an email seeking comment.

In their S.E.C. filings, 12 of 41 firms with actual or potential conflicts of interest framed their discount arrangements as actual ones. For example, Freeman Spogli & Company a $4 billion private equity fund, said, “There is often a conflict of interest between the firm, on the one hand, and the funds and portfolio companies, on the other hand.”

The five New York City pension funds overseen by Scott M. Stringer, the city comptroller, invest with Apollo, Blackstone, Carlyle, First Reserve and Freeman Spogli. Asked how he views the potential conflicts relating to vendor discounts, Mr. Stringer said: “The S.E.C. has raised serious concerns, and we support them taking a hard look at this issue. It’s clear that we still don’t have enough transparency from our private equity partners.”

So far, few pension funds or other investors have complained publicly about the discounts.

The South Carolina Retirement System Investment Commission, with $30 billion under management, uses private equity funds heavily and invests with Apollo. Asked about the firm’s practice of letting investors pay a premium for some outside work, Michael Hitchcock, the commission’s executive director, provided a statement.

“We will continue to work with our managers to reduce the overall fees we pay,” Mr. Hitchcock said, “and will place a particular emphasis on availing ourselves of the opportunity for fee savings due to our managers’ relationships with third-party service providers.”

In some respects, these issues are as old as Wall Street, where the interests of financiers and their clients have not always been aligned. A trenchant book on the topic first published in 1940 remains a classic. It is by Fred Schwed Jr. and carries the plaintive title “Where Are the Customers’ Yachts?”